Chapter 8: Short Term Financing - Ibrahim Sameer

Chapter 8: Short Term Financing 2014

Financial Management Bachelors of Business (Specialized in

HRM) ? Study Notes Chapter 8: Short Term Financing

1 Ibrahim Sameer

Bachelors of Business ? HRM (FM ? Cyryx College)

Chapter 8: Short Term Financing 2014

Introduction Current liabilities and short-term liabilities are debts or responsibilities of the company that must be settled in the period of a year or less. In summary, short term financing is very important in smoothing the daily operations of the company so that it would not be disrupted due to shortage of cash. Spontaneous Financing Spontaneous financing exists due to the daily activities of the company. For example, when the company's sales increases, the inventory must also be increased and these additional purchases are usually financed by trade credit. Spontaneous financing can also exist as a result of the differences in timing between the actual cash flow with the cash flow that should have occurred. For example, a company had obtained the services of company's employee for the period of 1 - 15 January but payments were only made on 16 January. The main sources for spontaneous financing are: (a) Trade Credit Trade credit is the credit facility offered by suppliers to customers. For suppliers, trade credits will be recorded in the balance sheet at the current assets section (account receivable). While for the customers, trade credits are located in the current liabilities section (account payable). This financing source is obtained based on the trust by the suppliers to customers. The cost of trade credit cannot be obtained directly, as the suppliers usually would not charge any interest on the trade credits offered. However, when the suppliers offer discount, customers will bear a higher effective cost if the discounts were not taken. Example 10.2 Inthi Company Plc Ltd has made a purchase on credit from the supplier for MVR800 on the terms of 3/10 net 30. If the company made the payment within 10 days, it will pay only MVR776 because the cash discount of MVR24 would be deducted from the invoice. In summary, the company is assumed to have made a loan of MVR776 for the period of 20 days with the interest payment of MVR24. Therefore, with the assumption of 365 days a year, the annual cost borne by Inthi Company Plc Ltd as a result of foregoing the discount offered can be estimated as follows:

2 Ibrahim Sameer

Bachelors of Business ? HRM (FM ? Cyryx College)

Chapter 8: Short Term Financing 2014

Based on the calculation above, Inthi Company Plc Ltd had to bear the annual cost of 56.4% if it did not accept the discount offer of 3/10 net 30. (b) Accruals Accruals exist when there is a delay in payment. For example, the employees' salaries will only be paid at the end of each month and also the employees' salaries deduction (EPF and SOCSO) by the employer will only be made on the 20th of the month. Financing sources through accruals do not involve any costs. It is free to the company as long as it does not affect the credibility of the company.

Negotiated Financing

The sources of negotiated financing are often obtained formally from financial institutions. It has

to undergo various procedures that have been predetermined. In this topic, we will focus on the

3 Ibrahim Sameer

Bachelors of Business ? HRM (FM ? Cyryx College)

Chapter 8: Short Term Financing 2014

facilities provided by commercial banks, which are overdrafts and short-term loans only. Other financing sources that will be discussed are commercial papers and factoring. (a) Overdraft Overdraft is a credit facility provided by banks to its customers. It is channelled through the customer's current accounts, where the customer is allowed to withdraw money in excess of the balance in its current account. However, there is a limit set on the withdrawal. For example, Inthi Company Plc Ltd received an overdraft facility for MVR50,000. This means that the company can use the funds provided by the bank until the balance in its account reaches MVR50,000. Overdraft facilities are very useful to a company that wishes to take the cash discount offered by the supplier. The cost that needs to be borne by the customer who uses the overdraft service is the interest that is applied based on the negative balance of the customer's current account. (b) Bank Loans Besides overdrafts, banks will also provide services for short-term loan facilities. To understand this negotiated financing via bank loans, see Example 10.3. Example 10.3 Inthi Company Plc Ltd has obtained a bank loan of MVR200,000 for a period of 3 months at the rate of 15% per year. At the end of the period, Inthi Company Plc Ltd repaid the principal together with its interest. Before making calculations for the effective cost of the loan, the interest amount must be ascertained in advance.

If you look at the above example, the effective cost of 15% is the same with the rate of the bank loan. However, there are two characteristics in the cost of short-term loan that will make its value higher than the nominal interest rate. These characteristics are the compensating balance and the discounted interest.

4 Ibrahim Sameer

Bachelors of Business ? HRM (FM ? Cyryx College)

Chapter 8: Short Term Financing 2014

(i) Compensating Balance The compensating balance is the amount that must be kept in the bank account and remained as a balance throughout the loan period. The requirement for this compensating balance makes the actual amount received by the borrower to be less by the compensating balance amount. However, the interest is still calculated based on the entire loan. By using Example 10.3 and several additional information, we can see the effect of the compensating balance on the effective cost of the loan. The bank that provides the loan imposed the condition for compensating balance to be 10% of the total loan. Assuming that Inthi Company Plc Ltd does not have the balance as required by the compensating balance. Calculate the effective cost of this loan. To obtain the effective cost of this loan, we need to obtain the value for:

Interest amount; Compensating balance; and Value of net loan These information can be calculated as follows:

Based on the calculation above, the effective cost of the loan is higher compared to the value before there was a compensating balance. (ii) Discounted Interest Through this characteristic, the borrower must pay interest when the loan amount is withdrawn. This means that the payment of interest has been settled in advance before the loan can be used. This condition makes the net amount obtained by the loan to be less than the amount borrowed. However, the effective cost still increases as the interest is made based on the entire loan. By using Example 10.3, the calculation of interest, net amount and the effective cost for Inthi Company Plc Ltd are as follows: Interest amount = MVR200,000 ? 15% ? 1.4 = MVR7,500

5 Ibrahim Sameer

Bachelors of Business ? HRM (FM ? Cyryx College)

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